Is it possible for an individual investor to replicate what professional bond managers do when buying individual municipal bonds?

Unfortunately I think the answer to this question is no, and here’s why.

A Lack of Available Supply

There is an inflexibility of supply in the municipal bond market for two reasons:

The municipal bond market is made up primarily of individuals, who are buying bonds for the tax free income, and holding until maturity. This means that once a bond is sold to an investor it often times does not come back onto the market again.

With corporate bonds, the supply of new issues can be heavily influenced by the demand for bonds and current interest rates. These factors play a much smaller roll with municipal bonds, which issue bonds primarily based on political considerations and budget constraints.

One major brokerage firm estimates that less than 10% of all municipal bond issues are available for retail investors to trade electronically at any given time. While most major brokerage firms offer electronic trading, the lack of supply available to the individual investor makes constructing an individual bond portfolio a major undertaking. Imagine how difficult it would be to trade stocks, if for every 10 times that you wanted to purchase a particular stock, you could only execute a trade once. (For more on the differences between trading stocks and bonds go here.)

The ability to better deal with the lack of supply in the municipal bond market is one area where institutions have a major advantage over the individual investor. Bond Funds and other types of institutions can access a supply of bonds which an individual cannot. They have information on which institutions own various bonds, and can contact them to arrange a transaction. If they do not already know where the bond they are looking for can be found, they can announce that they are interested in buying a particular bond issue, and solicit bids. The professional mutual fund manager (or their trading desk) also has the advantage of being constantly immersed in the market. While a bond might be available for a good price today, it might not be tomorrow or the next day. A professional trading desk can watch for attractive issues which have recently come up for sale and alert the portfolio manager to the potential opportunity.

Because institutions are constantly active in the market, they have access to more sellers, which fosters competition for their trades which is not available to the individual investor.

Because institutions are buying large amounts of bonds on behalf of many individuals, their trade sizes are generally much larger. Although not always the case, generally the larger the trade size, the more competition there is a for the trade, and the lower the transaction costs.

Institutions are generally more sophisticated than individuals, and therefore more likely to know a good price vs. a bad price.

Bottom line: an institutional investor is going to get a better price than an individual trader*.

(*Retail Offering Periods are one exception to the above rule. When a bond first comes to market, retail investors have may have an opportunity to get bonds at the same price as institutions. However, I believe building a portfolio solely around retail offering periods is not practical solution for individual investor looking to create a diversified portfolio over a short-period of time and would require fairly extensive commitment of time. You can learn more about retail offering periods here.)

Assuming the cost of investing in a municipal bond mutual fund is around 1% per year in management fees, the individual investor comes out ahead investing in the mutual fund on a cost basis, after factoring in how much more they would have to pay for the bonds. If you are interested in learning more about municipal bond mutual funds, check out the bond funds section of LearnBonds.com.

Comments

I think the best way for a beginner would be thurogh an Exchange Traded Fund. Mutual Funds require thorough research because you are trying to evaluate the abilities of individuals to actively manage your portfolio. Rather than spend that time (and money thurogh higher expense ratios), go with an ETF that will charge a tiny fee and give you broad exposure to the international markets.My recommendation would be to check out the iShares EAFE index fund (Ticker: EFA). It will provide you liquid, diversified exposure to Europe, Australia/New Zealand, and the Far East (Ex-Japan). If you have a bigger appetite for risk, you might also consider the emerging markets look at Ticker VWO from Vanguard or EEM from iShares.